NUA occurs when an employer-sponsored plan allows the employee to purchase employer securities as part of the qualified retirement plan. The IRS treats these securities held inside the plan differently from the way it treats other assets such as cash and mutual funds when an employee retires.

When the employee rolls over his qualified plan to an IRA, he/she has the opportunity to withdraw his employer securities and pay income tax on the cost basis (not the current value) and capital gains tax on the gain if he sells the employer securities. The cash, mutual funds or other investment accounts will roll over into the IRA and are not taxed until withdrawn.

Case Study:
Let’s use the following case study to explain this. Mr. Smith, age 65, has a 401(k) plan valued at $500,000. $250,000 is in mutual funds, and $250,000 is in company stock. The basis on the company stock is $50,000. Assume Mr. Smith is in the 25 percent federal income-tax bracket

Option 1: The normal rollover approach
Mr. Smith rolls the entire account into an IRA. Any normal distributions he takes will be taxed in the 25 percent federal income tax bracket. At age 70, he will be forced to take required minimum distributions (RMDs) and pay taxes on these distributions in his then applicable (assumed 25 percent) tax bracket. (See IRS Publication 590)

Option 2: The NUA Rollover approach
Benefits of NUA

Mr. Smith rolls the stock out of the 401(k) plan. The basis on the stock is $50,000, and he must pay ordinary income tax on the basis of $12,500 ($50,000 x 25 percent tax rate). The stock is transferred to a nonqualified account. No additional taxes are owed on the stock until he sells it. Assume he does sell the stock. He pays capital gains tax on the sale vs. ordinary income and is thus taxed at 15 percent (current maximum capital gain tax rate), not 25 percent. This creates an immediate tax savings of 10 percent. Shares sold under this technique are taxed at long-term capital gains tax rates (up to the NUA), regardless of the length of time between the roll-out and the sale of the stock and short- or long-term gains on any additional gain beyond the NUA based on the time of sale. If he does not sell the stock, there are no additional taxes beyond the ordinary income tax due on the rollout. All other remaining funds are rolled into an IRA.

NUA offers many advantages:
First, it will reduce your client’s overall tax burden on the 401(k) plan, and he can have the opportunity to use capital gains tax rates vs. ordinary income tax on $200,000 of the value of the account.

Second, by reducing the amount rolling into the IRA, you will reduce the RMD amounts when the client reaches age 70.5. RMD’s are calculated on the year-end balance of the IRA. If you remove the value of the stock from the account, it will not be included in the RMD calculation.

Third, Capital gains tax rates are significantly lower than the current income tax rates.